Why the commodities rally may not last much longer (and what it means for ASX materials stocks)

About a week ago, our brilliant managing editor Chris Conway wrote a piece discussing whether the end is nigh for the iron ore rally. The idea is simple - a slowdown in the Chinese economy without any extra stimulus may spell bad things for the price of Australia's most valuable export. 

A research note from mid-last week appeared to confirm this view. Citi noted that although steel output cuts have been smaller than expected, the rally won't likely last. The team has a year-end forecast of just US$90/tonne for the commodity.

We think the recent strength is unlikely to be sustained as effective stimulus measures will be difficult to achieve and a supply side response is also not our base case.

But one research house has gone even further. In a 78-page research note, the UBS global commodities team suggested that history will not repeat itself this time - and that the fundamentals for a sustained rally in iron ore, copper, and steel don't exist even if Chinese economic activity is finally starting to bottom out. And if they are right, that could pose big problems for the major materials names on the ASX. 

In this wire, I'll summarise the key insights from the report and share what it all means for shareholders of the Big Three and two other stalwarts.

The theory (and the mixed proof)

History has suggested that the bottoming out in the purchasing managers index (PMIs) of several key economies can also herald an inflection point for commodity spot prices. 

UBS notes there have been nine PMI lows since 2010, and that while commodities do experience a boost - it's rarely long-lived.

"History suggests the bounce in commodity prices and miners may continue as PMIs may have bottomed and investor positioning is neutral/short. However, this data does not provide meaningful conclusions over 6-12 months, consistent with our view that fundamentals have more influence on longer-term performance," analysts wrote.

Here's what they found:

• In the six months following a bottoming out in PMIs, the Bloomberg Mining Index only delivered positive returns 5 out of the 9 times. 

• In the twelve months following a bottoming out, the Bloomberg Mining Index only delivered positive returns 3 out of 9 times.

• For the China PMI specifically, it bottomed three times during the commodity bear market between 2011 and 2015. Over that time, the miners still generated average negative returns of about 20% over the following 12 months.

The caveat to this research is that this is a global mining index, meaning the performance of the Australian miners is mixed in with its international peers. 

So, what about the ASX miners?

I'm glad you asked. Let's start with the biggest of them all.

Iron ore: The top is in

UBS estimates that the iron ore market will end up returning to surplus as soon as the second half of this calendar year. With supplies rising, UBS has a price target of US$111/tonne for the end of 2023. 

Further to this, if its thesis plays out, that price could fall to US$76/tonne by 2025 (though it should be said that these forecasts rarely stick and do change significantly from time to time). 

UBS has SELL ratings on the following names - BHP Group (ASX: BHP), Rio Tinto (ASX: RIO), and Fortescue (ASX: FMG). In fact, of the eight stocks under its global coverage, none have a BUY rating as of publishing. Mineral Resources (ASX: MIN) was the only Australian company to have a NEUTRAL rating.

Steel: Under pressure

In China, steel prices will likely remain weak given the recovery in demand has been so mild following the reopening in late 2022. This is despite utilisation rates remaining near 90%, suggesting high exports are also playing a role in dampening prices. But how about elsewhere?

"We expect EU prices to fall in June as restocking loses momentum and import pressure grows. US steel prices will likely continue to roll over as import orders are rising (a function of falling import prices) and service centre restocking is slowing," analysts wrote."

There is only one major ASX steel play, BlueScope Steel (ASX: BSL) that actually earns a BUY from the analysts. But you should know that the stock has also been identified as a "crowded long" (that is, the price may be higher for longer as lots of people are in the trade already). 

Copper: Growing upside risks

Finally, a brief word on copper given no Australian stocks are mentioned in their coverage of this particular commodity. Based on active ownership data, we observe global investors mostly have larger overweight positions in copper equities vs both the global materials sector and the broader equity index compared to pre-China reopening.

Source: UBS

Source: UBS

But unlike the outlooks for steel and iron ore, UBS is actually more cautious on the copper outlook near-term rather than long-term. And they are keen to point something else out too.

"We are not perennial copper bulls and whilst remaining constructive on the long-term outlook, we have been more cautious on the fundamental outlook near term. Following the recent sell-off, we believe the copper market is closer to a fundamental inflection point. We forecast only a modest market surplus in 2023, moving to a growing deficit from 2025."

This increases the risk of material price upside over the next 2-3 years (potentially creating a "lithium moment" for copper).

You heard it here first, folks.

This article was first published for Livewire Markets on 12 June 2023.